Federal Reserve officials are widely expected to announce Wednesday that short-term interest rates will remain near zero, leaving mid-December as the central bank’s last chance to raise rates this year.
The timetable poses twin challenges for Fed Chairwoman Janet Yellen: Deciding whether the U.S. economy is ready for an interest-rate increase, and signaling central bank intentions without causing further market confusion.
In September, shaky economic conditions delayed a long-expected rate increase and many investors criticized mixed signals by Fed officials in the days before and after the decision—a dynamic partly of Ms. Yellen’s making.
With attention now focused on whether the central bank will act before year’s end, the pressure is on the Fed to better manage expectations for rates and the U.S. economy.
Officials have their work cut out, as illustrated in this recent exchange:
“I don’t really understand what is unclear right now,” said William Dudley, president of the Federal Reserve Bank of New York, during an appearance at a panel in Washington this month.
“Are you kidding?” Stanford University economist and Fed critic John Taylor said. “No one knows what you’re doing.”
This is more than economic theatrics. What the central bank says can send the dollar, borrowing costs and stock prices on wild rides up or down, eventually affecting pocketbooks across the U.S.
Ms. Yellen’s own inner circle of advisers has at times been out of sync in the long-running debate. Fed governors in Washington, meantime, want to delay a rate increase while pushing back against regional bank presidents eager to get started.
“I’m scratching my head about why so much of this is going on outside of the building,” said Princeton University professor Alan Blinder, a former Fed vice chairman.
Uncertainty spreads
The Fed’s uncertainty is contagious. A Wall Street Journal survey of market economists this month found that 64% believe the Fed will raise rates by December. Futures markets put the odds at 35%.
One cause of the confusion isn’t the fault of the central bank. The economy isn’t cooperating. With unemployment falling rapidly, Ms. Yellen and most of her colleagues began the year thinking the economy would be strong enough to lift rates.
The Fed didn’t want to catch investors by surprise, so it gave warning. As early as March and as late as June, all but two Fed officials expected an increase in the benchmark short-term rate this year. But inflation hasn’t picked up as expected. And China’s slowing economy has stoked uncertainty.
The projections of a 2015 rate increase weren’t meant to be a commitment, but they were taken that way by many investors and commentators. As the likelihood of a move diminished, the Fed has looked like it was waffling.
The central bank has said it would raise rates after more progress in the job market, and when officials become “reasonably confident” inflation is rising toward the central bank’s 2% target after running below it for more than three years.
But Fed officials are divided over what defines progress in employment, as well as confidence in the movement of inflation.
Furor over the Fed’s mixed signals has only grown louder, as the decision about rates has gotten more complicated.
The responsibility of managing the various viewpoints inside the central bank falls to Ms. Yellen, who is supposed to forge consensus. She meets regularly with other Fed governors and schedules calls with every regional bank president before meetings. More social than her predecessor, Ben Bernanke, she mills about at Fed dinners after policy meetings, according to officials.
As Fed vice chairwoman from 2010 to 2014, Ms. Yellen was a vocal proponent of the Fed’s easy-money programs. Since taking over as chairwoman in early 2014, Ms. Yellen has followed Mr. Bernanke’s style of seeking consensus and given voice to disparate views at the Fed.
Divisions begin with Ms. Yellen’s inner circle: Stanley Fischer, the Fed vice chairman, and Mr. Dudley, the New York Fed president.
Ms. Yellen and Mr. Fischer—a former economics professor at the Massachusetts Institute of Technology and former chief of Israel’s central bank—are close. They eat lunch together every week at the rooftop cafeteria of the Fed’s Martin Building with a view of Washington, according to people who know them.
Over plastic trays, Diet Coke and coffee, the two colleagues discuss the U.S. economy and plot strategy.
Mr. Dudley often dials into meetings with Ms. Yellen, Mr. Fischer and senior staff members to discuss the economy and policy, according to people who know them. He also dials in as Ms. Yellen prepares for her quarterly news conferences, joining Mr. Fischer and others to plan her responses.
The three leaders interact routinely, a process that intensifies in the lead-up to policy meetings as they work together on draft policy statements, according to people who know them.
But they hold their own views. Mr. Fischer is among those more eager to raise rates. Mr. Dudley has been hesitant. To the dismay of investors, a split in their views surfaced a few weeks ago.
In August, Fed officials were concerned that a stronger dollar, falling stock prices and rising rates on corporate and other debt had tightened financial conditions and could restrain the economy.
It was a hectic time. Ms. Yellen was at home in Berkeley, Calif. Mr. Fischer was traveling, first to California and Colorado, then to Wyoming for the Kansas City Fed’s annual retreat in Jackson Hole. Mr. Dudley was preparing for a news conference in New York on its regional economy.
On Aug. 25, markets reeled over worries about China’s economy. The Dow Jones Industrial Average dropped 204.91 points, and was off more than 10% over six trading days, the biggest correction over such a span since the financial crisis.
Ms. Yellen conferred with Mr. Dudley and Mr. Fischer several times by phone that week, sometimes jointly, said people familiar with the matter.
On Aug. 26, speaking to reporters, Mr. Dudley largely stuck to a view he shared with Mr. Fischer and Ms. Yellen.
“It is important not to overreact to short-term market developments because it is unclear whether this will just be a temporary adjustment or something more persistent that will have implications for the U.S. growth and inflation outlook,” he read from a written statement.
Then, at the end, he offered his own opinion. A rate increase at the coming September meeting, he said, “seems less compelling to me than it did a few weeks ago.”
Two days later, Mr. Fischer, speaking on CNBC, tried to dial back the impression his colleague created, hoping to give the Fed leeway at the meeting. “I wouldn’t want to go ahead and decide right now what the case is, more compelling, less compelling, et cetera,” he said.
Mr. Dudley later played down the fissures, noting he and Mr. Fischer both emphasized the Fed’s decisions depended on the evolution of economic data. “We’re mostly on the same page,” he told the Journal.
Three camps
Ms. Yellen, who won a 9-1 vote to hold rates steady at the September meeting, must bring together three different camps inside the Fed.
One group, which includes several regional bank presidents, is ready to act on rates. Another, which includes Ms. Yellen and her core leadership, is poised for a rate increase if hiring and economic output keep growing at a healthy clip.
The third group of presidents and governors is called by some the “show-me camp.” They want to see concrete signs that inflation or wages are going up before raising rates. This group could help Ms. Yellen build a consensus around her centrist stance by counterbalancing the eager-to-move group.
As Mr. Dudley and Mr. Fischer showed, the views can vary within various Fed camps.
Fed governors Lael Brainard and Daniel Tarullo independently set out after the September meeting to challenge the case made by some regional bank presidents that the Fed should start raising rates. Ms. Brainard in a speech in Washington this month and Mr. Tarullo in a CNBC interview the next day said they preferred to wait to see inflation rise before the Fed moves.
In pushing against the Fed bank presidents who want to raise rates, Ms. Brainard and Mr. Tarullo in their comments also challenged Ms. Yellen’s view that inflation will rise once unemployment falls further. They said they weren’t convinced there was much connection between unemployment and inflation.
Ms. Yellen believes inflation will rise as slack in the economy diminishes and a falling jobless rate is central to her case. She decided months ago that she needed to explain in more detail why the Fed was considering raising interest rates when inflation had been running below the central bank’s 2% target for so long, according to people familiar with the matter.
The Fed’s favorite measure of slack is the unemployment rate. Her view is linked to work of economist A.W. Phillips, who determined a half century ago that when unemployment rates go down, wages go up, and vice versa.
If the Fed can’t make a persuasive argument that inflation is set to rise, it has little case for raising rates.
The distance between Ms. Yellen and the two governors actually wasn’t as great as it appeared, as she revealed in her long-planned speech on inflation that she delivered after the Fed’s September meeting.
Ms. Yellen acknowledged in the speech that despite the long-held economic theory, the connection between the unemployment rate and inflation was tenuous. If it were strong, inflation would have tumbled when unemployment soared to 10% in 2009 and rebounded as joblessness fell. Instead, the inflation rate drifted lower and then got stuck below 2%.
“The theoretical underpinnings of the model are still a subject of controversy among economists,” Ms. Yellen said in the Sept. 24 speech. “The validity of forecasts from this model must be continuously evaluated in response to incoming data.”
To observers, it served as a meaningful clue. If, in the weeks ahead, the data don’t confirm to the Fed’s projections of solid growth and hiring—and if the numbers don’t hint at a gradual rise in inflation—she and her colleagues won’t be moving interest rates much, if at all.